The last thing I want is to be self-important, but if you have Australian investment portfolio’s then I’d humbly suggest that you take 5 minutes to read through some of my thoughts in response to the tumultuous week we are witnessing in Canberra.
Firstly, this is NOT a politically-tinged piece.
The prospect of a Labor Federal Government is now a very real thing, and that parties proposed policy has significant implications for local investment markets and asset values.
Labor policy takes aim at asset owners
The main concern relates to Labor’s proposed taxation policy on both housing investment and dividend income.
On housing, both the Labor and Green opposition parties are strongly in favour of unwinding the system of tax breaks afforded to housing investors, known as negative gearing.
With housing markets already starting to roll over after 5 years of incredible gains, a change to negative gearing would further compound the likely downside in house prices, potentially fueling a sharp downdraft in consumer confidence.
For well over a decade, investment lending has comprised over 30%+ of all mortgage lending, giving you some sense of its importance to the Australian housing market. Whilst Labor have said existing agreements will be grandfathered and that negative gearing can continue on new builds, the broad removal of these tax incentives lessens the attractiveness of property as an investment asset for all new potential housing investors.
Like in any market, when the value of an income stream is reduced, the marginal buyer lowers his price.
Making this potential policy change all the more concerning is Australia’s current degree of household indebtedness.
Compounding Australia’s indebtedness, the provision of liquidity to the economy has dried up to the extent that Australian money supply growth is now running at its lowest rate since the 1990’s recession. As any businessman or woman knows, cashflow is everything, so with credit getting tighter and tighter, and housing already on the slide, the prospect of more forced sellers of Australian property looms large in the event of a Labor Federal Government.
On tax, it’s a similarly concerning story. Whilst the Labor policy on corporate tax cuts isn’t helpful nor a surprise, Shadow Treasurer Chris Bowen’s platform to abolish cash tax payments for excess franking credits should strike fear into the heart of many self-directed retirement investors since it will most certainly remove 1-2% from the annual dividend income on a typical accumulation or pension account Australian equity investor.
If you fall into that bucket, like many of our clients do, you are right to feel aggrieved.
With the introduction of the $1.6m tax-free cap on superannuation last year, cuts to blue-chip Australian dividends (BHP, banks, Telstra etc) over the past 3 years and the virtually non-existent returns on cash, my guess is that income to a retiree on what was a ‘typical Australian portfolio’ has fallen by well over 3% annually in the past 5 years, which is a huge hit.
Removing rebates on excess imputation credits would be the latest in a string of blows to retirement incomes.
Like in the instance of a repeal to negative gearing, if the value of excess franking credits is abolished, then the value of that income stream is diminished and hence deserving of a devaluation. Again, just like in the case of housing, if what was once a 7% annual income stream becomes a 5% income stream, then the asset on which that income stream is derived is instantly worth as much as 30% less to the owner.
So just to be super clear, under a Labor Federal Government, the value of franked income streams to a large proportion of Australian stock-market investors will be diminished to the tune of 20%+ across the board.
Which means they will sell these assets.
Australia portfolio construction set for a major shakeup
Make no mistake, this Federal Election stands as a potential catalyst for a sea-change in the way retirement portfolios are constructed in this country.
Buoyed by the combined tax benefits of both dividend imputation and Australia’s superannuation system, Australian retirement portfolios have leaned heavily on Australian-listed, income generative, large cap corporates.
Despite Australian shares comprising less than 2% of the world equity index by value, many local retirement portfolios have remained anchored by tax-advantaged Australian listed investments, including both equity and hybrid securities. Many portfolios remain dominated by major banks, Telstra (TLS), Wesfarmers (WES), Woolworths (WOW), listed hybrid-securities and cash, and this hasn’t worked for many years.
The potential policy changes will act to compound underperformance of these portfolios.
Moreover, with a potential change in policy comes the horrible realization to many investors that the income generated off their investment portfolios might now fail to provide for annual pension payments, meaning that capital will have to be drawn down.
This is going to be a big psychological change to many retirement investors who have become used to the idea that their tax-advantaged capital accrued in superannuation accounts would provide a stable income for retirement without risk of that capital being eaten into.
Potentially, no longer.
This is precisely why I am pointing this all out.
A Labor Federal Government who follows through on the policies outlined above will make a significant change in the way we invest here in Australia.
How do you mitigate against these risks?
Obviously, there is a heap of things to consider.
As the risk-return profiles of different asset classes change, so too should investors consider their asset allocation.
We have been making increasing noise for many years around the need for increased international equity exposure, raising our recommended weights on foreign shareholdings to equal or more than domestic equity allocations.
Perhaps we didn’t go far enough?
Australian investors will rapidly seek to reappraise the value of capital growth in return profiles at the expense of franked income, and this, alongside a likely fall in the Australian Dollar, will benefit those holding offshore equities.
Equally on bank-hybrid securities, on which over 30% of the annual income from most issues is derived from franking benefits, investors need to consider the potential cut to the value of their income under a Labor Government, and to seek alternate forms of consistent income.
Mortgage funds, corporate credit funds, infrastructure and even conservatively geared commercial property funds will likely see significant interest. We have championed several of these funds in the past year and would happily provide more detail as appropriate.
This is important stuff for many people.
Yes, Labor are yet to be elected. Yes, Labor could well back-track on both policies. But then, they might get elected, and they might power ahead with the youth vote on both.
Either way, many portfolios are skewed entirely in one direction with little consideration for the risks outlined above and must be addressed.
I would think that Australian assets will underperform USD assets in the coming 6 months or so, depending on election timing and result, and probably quite significantly (10%+). The Australian Dollar will likely bear the brunt of foreign investor concerns in relation to a collapsing asset bubble, and will most likely find its way deep into the 60’s.
Australian banks will continue their bout of underperformance, hit by the double-whammy of falling housing markets and equity investors revaluing bank franked income streams.
Long-dated hybrid securities (2022+ maturities) will likely weaken.
Holding some cash, considering alternate income streams and having strong exposures to offshore equities will place portfolios in an excellent position to navigate what looks likely to be a very tricky time for Australian asset markets in the months ahead.
Please note, that in mid-March we warned of our rising caution. We were early. Australian shares have continued on by a further 5%, but we still feel very comfortable in our views, and would highlight that our portfolio recommended performance has not suffered from our creeping conservatism.